The Massive Drop In The Fed's Custody Holdings Of Treasuries This Week Reminds Us Of The Russian Invasion Of 1957

Talk that Russia could be behind the bulk of the more than $100 billion drop in the Federal Reserve's custody holdings for foreign central banks in the week ending Wednesday has many observers scratching their heads. This would represent about eighty percent of their dollar holdings.

As we noted earlier, rather than selling the Treasuries, Russia simply transferred them from the Federal Reserve out of the U.S. The incentive would be the threat of sanctions following this week's Crimean referendum.

There is precedent for this kind of behavior from Russia. Recall the origins of the Eurodollar market. The Eurodollar market has nothing to do with the European Economic and Monetary Union (EMU) or the euro itself. Rather, the Eurodollar market refers to dollars outside the U.S., initially Europe.

In 1956, the U.S. and the Soviet Union opposed the British and French (and Israeli) invasion of Egypt (Suez Crisis). The U.S. threatened to sell British pounds and intensify the pressure it was already experiencing in maintaining it peg to the dollar under Bretton Woods. It also threatened to veto the U.K.'s request for a large IMF assistance package. Russia witnessed the U.S. willingness to use its financial acumen to impose its will on its special ally.

At roughly the same time, a reformist government came to power in the Hungary and among other things tried to leave the Warsaw Pact. The Soviet Union invaded. Russia feared that the U.S. would use its financial superiority against it in protest. In 1957, Russia-based Narodny Bank shifted dollars from the U.S. and deposited them in its branch in London. Viola, the birth of the Eurodollar market.

There were other advantages of this offshore market for U.S. dollars beyond the Soviet Union's intentions. Those dollars were not subject to U.S. interest rate cap or regulations. These dollars, as we know with the benefit of hindsight, became the basis for a new bank credit, and a critical part of international finance.

The logic now is that Russia is bracing for the next round of sanctions. The U.S. and Europe are reluctant to confront Russia with militarily. U.S. and Europe did not confront Russia militarily after the Soviet Union invaded Hungary or Czechoslovakia, and it wasn't that Eisenhower or Johnson (the respective presidents at the time) were weak as some claim about Obama. Nor did President Bush confront Russia with arms when it invaded and continued to occupy parts of Georgia in 2008.

To be sure, the Federal Reserve does not publish the client list of who uses its custodial services. As we noted, some suggest it could be China diversifying reserves out of dollars and ostensibly into euros, which would help explain the persistent euro strength. However, we are a bit more skeptical of China in that it has a lot of its plate presently. The timing of the drop in custody holdings makes Russia a more likely suspect. The intervention by emerging-market central banks, including Russia, seem far too small to account for $100 billion move in a week.